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Italy's Options All Look Terrible

(Bloomberg Opinion) -- Spare a thought for Luigi Di Maio and Matteo Salvini. Italy’s youthful deputy prime ministers have little idea of how they will cobble together a budget for next year. The two leaders of the ruling Five Star and League parties must try to stick by their expensive promises to voters, while not upsetting Italy’s euro zone allies and the financial markets. It’s an impossible task.

So it’s natural enough that Di Maio and Salvini have retreated into their comfort zone: Electoral campaigning. And politically, this month’s European Parliament elections will carry more weight than usual in Rome. The League is nominally the junior partner to Five Star in Italy’s ruling coalition, but it has jumped well ahead in the polls. If Salvini beats Di Maio in the forthcoming European vote, he would be in a strong position to ask for a government reshuffle in his favor – or even a new national election.

Di Maio is fighting for his political survival since he knows that a heavy defeat could spark a revolt within Five Star against his leadership. For this reason, he has shifted the party to the left, playing the card of social justice and responsibility. The result is that his party is now squabbling daily with its partners in the right-wing League.

All of this is of great interest to aficionados of Italian politics. But to markets, it’s just another distraction. What investors care about is having a government in Rome that’s capable of dealing with the vast challenges facing the Italian economy: Slow growth, a rising deficit, and one of the largest public debts in the euro zone. Sadly, regardless of which of the two populist leaders are in the ascendant, such seriousness is nowhere in sight.

This is starting to take its toll again in the markets, and understandably so. The spread between Italy’s 10-year bond yields and German bunds has widened to 290 basis points this week, the highest since March. Salvini managed to spook everyone with his comments about Rome being prepared to bust the euro zone’s fiscal rules to cut Italian unemployment to below 5%. This was the first blow in a new confrontation with the European Commission that will kick off in earnest in the autumn.

But, as ever, while Salvini picks fights with outside forces, Italy’s problems are largely of its own making. The combination of political and economic uncertainty that’s marring the country is disastrously timed given the rising anxiety around global trade.

Sergio Mattarella, Italy’s president, is considering holding an election as soon as the autumn if the government collapses and there’s no alternative majority, according to Bloomberg News. But even that’s unlikely to make much difference to the markets.

The Five Star Movement could in theory consider an alliance with the center-left Democratic Party, which has shifted further to the left under its new leader, Nicola Zingaretti. Yet the Democrats may be divided over the prospect of teaming up with the populists. A resurgent right of center alliance between Salvini and Silvio Berlusconi’s Forza Italia would be more coherent than the current coalition. But Salvini would need to shift a long way from his current fiscal position to reassure investors.

The best hope for Italy, probably a forlorn one, is that its new caste of political leaders realizes the size of the challenge it’s facing. The immediate signs aren’t encouraging. For next year alone, the government has earmarked more than 20 billion euros ($22.4 billion) in VAT increases to try to keep close to deficit targets. That would have a negative effect on the consumer. Far preferable to find spending cuts to avoid this sudden tax increase. But, for all the campaign rhetoric about slashing waste, there’s no sign of the coalition actually doing it.

As the global economic outlook darkens because of the trade conflict between the U.S. and China, financial markets are likely to stay defensive. Once the European electoral campaign is over, politicians would be wise to start thinking of a better case for keeping investors in Italy.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.